Much has been said about the current market valuation and expected returns. Investors who paid attention to this have been punished badly, as the current market valuation would suggest them avoid stocks. As a matter of fact, the market is indeed positioned for returns in the order of 3% per year for the coming years.

Three percent may sound unacceptable, but everything else is returning even less. Thanks to Fed’s zero interest policy. Where do you put your money? Are you chasing returns? If you think too much, you would be cautious and put your money in cash or hedge your stock positions. Those who pay no attention to long-term market valuations are rewarded greatly, as least for now. Who knows when the music will stop!

The current market momentum may interrupt a 45-year winning streak of Warren Buffett, with which he has beaten the market average in any rolling 5-year period since he took over Berkshire Hathaway (BRK.A)(BRK.B). Buffett discussed this in his latest shareholder letter. “We do better in headwinds.” He wrote.

Buffett is not alone. Prem Watsa has lost more than $1 billion to his equity hedges in 2012. John Hussman has largely lost his creditability to a lot of investors for his bearishness. His fund has underperformed the market significantly in the last several years.

“We do better in headwinds.” This is also true for GuruFocus Value Strategies. Our Buffett-Munger model portfolio has been underperforming, too, although it outperformed the market from 2009 through 2011 and the overall outperformance is 22% since 2009. This is frustrating, but we are going to stick to our philosophy of investing in high quality companies at reasonable prices.

Let’s back to our topic if you still want to read. Where are we with market valuations?

As pointed out by Warren Buffett, the percentage of total market cap (TMC) relative to the U.S. GNP is “probably the best single measure of where valuations stand at any given moment.” You can learn the details on why this is important and how we do the calculation in our Market Valuation page. This page is updated daily.

As of today, the Total Market Index as measured by the Wilshire 5000 index is at $16,258.5 billion, and it is now 104.6% of the U.S. GDP. The stock market will return about 3% a year in the coming years, including dividends. As a comparison, in January 2012, the ratio of total market cap over GDP was 87.4%, it was likely to return 5.7% a year from that level of valuation. The 20% gain since the beginning of 2012 has reduced the future gains by about 2.7% a year.

The historical prediction from this model and the actual market performance is show here:

Historically since 1970, only two periods had comparably low market returns, which are the late 1990s and 2007. Both were followed by steep market declines.

Shiller P/E Ratio

Prof. Robert Shiller of Yale University invented the Schiller P/E to measure the market's valuation. The Schiller P/E eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles and tries to give a fair market valuation. You can learn the details of why we use Shiller P/E and how it is calculated in the GuruFocus Shiller P/E page.

At 23, the Shiller P/E is 37.6% higher than the historical mean of 16.5. The implied future annual return is 2.2%, including dividends. As a comparison, the regular trailing 12-month P/E is 18, slightly higher than the historical mean of 16. That is also why the media pundits are saying that the market is cheap.

John Hussman uses the peak P/E ratio to smooth out the distortion of the corporate profits caused by the fluctuations of the profit margins. The current market return projected by his model is around 3.5% a year.

This is the historical prediction and the actual market performances from his model:

Dr. Hussman rightly pointed out that “it is only hindsight that tempts investors to believe that it would have been easy to maintain a defensive position in response to the warning signs.” But if you “put yourself in the shoes of investors during that ramp to new highs day-after-day,” all you have is probably frustration.

GMO expected U.S. large cap real return (inflation adjusted) is -0.6%. This number agrees with what we find out with market/GDP ratio and Shiller P/E ratio. The U.S. high quality will have higher return. The return is expected to be 4.1% a year.

Insiders

If average investors are excited about the current market, companies' insiders, including CEOs, CFOs and directors are not. The insider buy/sell ratio is close to its lowest level. It sits at 0.22 now.

Historically, if this ratio is above one, it means that more insiders are buying than selling. This happened twice since 2004. One is during the period of bear market from October 2008 to March 2009. The other is after the mini crash of September 2011. Both were proved to be great buying opportunities.

This is the historical ratio of insider buys over insider sells:

Distressed Areas

Although the market is hot, it is not universally so. Many industries are traded at three-year lows. This might be an area to find bargains for real value investors. You can see the industries that are out of favor from the page of Stocks at 3-Year Lows and 5-Year Lows.

Because the market will return 2% to 3% a year for the next couple of years, most of the future returns will be from dividends, and the market index will likely to be flat even after many years.

If you want to stay in the market, historical market returns prove that when the market is fair or overvalued, it pays to be defensive. Companies with high quality business and strong balance sheet will provide better returns in this environment.

If you are looking for these kind of companies, please check out GuruFocus' Buffett-Munger Screener. "Buffett-Munger Screener" is the screener we created to find companies with high quality business at undervalued or fair-valued prices:

Companies that have high Predictability Rank, that is, companies that can consistently grow their revenue and earnings.Companies that have competitive advantages. They can maintain or even expand its profit margin while growing its business.Companies that incur little debt while growing business.Companies that are fair valued or under-valued. We use PEPG as indicator. PEPG is the P/E ratio divided by the average growth rate of EBITDA over the past five years.If you are not a Premium Member, as always, we invite you for a 7-day Free Trial.

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